The Determinants of Volatility Timing Performance

Abstract

The exact conditions under which volatility timing strategies yield value are documented. These conditions include: the ability to correctly forecast next period stochastic variance, and violation of a strict version of Merton's intertemporal capital asset pricing model (ICAPM). While the empirical evidence supports the first of these conditions, the latter remains open to debate. Our empirical results confirm the former, but demonstrate a significant violation of the (strict) ICAPM. It follows that volatility timing strategies appear to have value. However, using reasonable parameter values plugged into the derived formulae, the results also show that extreme leverage is often required for success. A method of tempering leverage is proposed, which is somewhat able to loosen the requirement of high leverage while still maintaining a good performance level. Given the likely variation in (strict) ICAPM violations across time and assets, it follows that volatility timing success (or failure) is very much sample dependent.